Right

What Is a Right?

In finance, a right refers to a financial instrument, typically issued by a company to its existing shareholders, granting them the privilege to purchase additional shares of the company's common stock in proportion to their current holdings. These instruments fall under the broader financial category of Securities and are often referred to as subscription rights or Preemptive Rights. A key purpose of issuing a right is to allow existing Shareholders the opportunity to maintain their proportional ownership in the company and avoid Dilution when new shares are issued. Companies utilize rights as a method of Capital Raising.

History and Origin

The concept of preemptive rights, which forms the basis of a financial right, emerged prominently in the late 19th century. This development was a response to the rapid expansion of joint-stock companies and the increasing concern among existing shareholders about maintaining their proportional ownership stakes when new shares were issued. Prior to formalization, shareholder rights were often informal, leading to situations where majority shareholders could dilute minority interests through new share issuances. The introduction of the principle of preemptive rights provided existing shareholders the first opportunity to purchase additional shares before they became available to other investors. This represented a crucial evolution in corporate governance, aiming to balance the interests of diverse shareholders and mitigate potential abuses of power by controlling stakeholders.⁴

Key Takeaways

• A right, or subscription right, provides existing shareholders the privilege to buy new shares, typically at a discount, before they are offered to the general public.
• The primary purpose of a right is to protect existing shareholders from the dilution of their ownership percentage in the company.
• Rights are often short-term, with a specified expiration date, and may be transferable, allowing shareholders to sell them on an exchange.
• Companies use rights offerings as a method to raise capital from their current investor base.
• Failing to exercise or sell a right can lead to dilution of an investor's ownership stake.

Formula and Calculation

The theoretical value of a right can be calculated both "rights-on" (before the new shares begin trading ex-rights) and "ex-rights" (after the shares begin trading without the right attached).

Value of a Right (Rights-On):
This formula calculates the value of one right when the stock is still trading with the right attached.

Where:

• (V_{RO}) = Value of one right (rights-on)
• (M) = Market price of the stock (rights-on)
• (S) = Subscription price (or Exercise Price) of the new shares
• (N) = Number of old shares required to subscribe to one new share

Value of a Right (Ex-Rights):
This formula calculates the value of one right after the stock begins trading ex-rights.

Where:

• (V_{ER}) = Value of one right (ex-rights)
• (M_{ER}) = Market Value of the stock (ex-rights)
• (S) = Subscription price of the new shares
• (N) = Number of old shares required to subscribe to one new share

Interpreting the Right

Interpreting a right primarily involves understanding its value and its implications for existing Shareholders. The theoretical value of a right indicates the discount at which new shares can be acquired, compensating existing investors for the potential Dilution of their stake. If the market price of the common stock is significantly above the subscription price, the right will have substantial value, encouraging shareholders to either exercise it or sell it.

Shareholders can choose to exercise their rights to purchase additional Common Stock, thereby maintaining their proportional ownership and voting power. Alternatively, if the rights are transferable, they can sell their rights in the market, converting their value into cash. Those who neither exercise nor sell their rights will experience dilution, as their percentage ownership in the company will decrease once the new shares are issued. The decision often hinges on an investor's desire to maintain their stake, their liquidity needs, and their assessment of the company's future prospects.

Hypothetical Example

Imagine "GreenTech Inc.", a publicly traded company, needs to raise capital for a new sustainable energy project. GreenTech's Common Stock is currently trading at $50 per share. The company announces a rights offering where existing shareholders receive one right for every four shares they own, allowing them to subscribe to one new share at an Exercise Price of $40.

Scenario: An investor, Sarah, owns 400 shares of GreenTech Inc.

1. Calculate Rights Received: Sarah receives 400 shares / 4 = 100 rights.
2. Calculate New Shares Eligible to Buy: Each right allows her to buy one new share, so she can buy 100 new shares.
3. Calculate Total Cost if Exercised: 100 shares * $40/share = $4,000.
4. Calculate Theoretical Value of One Right (Rights-On):
   Using the formula (V_{RO} = \frac{M - S}{N + 1}):
   (V_{RO} = \frac{$50 - $40}{4 + 1} = \frac{$10}{5} = $2.00)
   So, each right has a theoretical value of $2.00.

Sarah's Options:

• Exercise: Sarah can pay $4,000 to subscribe for 100 new shares. After exercising, she would own 500 shares (400 old + 100 new), maintaining her proportional ownership in GreenTech Inc.
• Sell: If the rights are transferable, Sarah could sell her 100 rights in the market. Assuming they trade near their theoretical value, she could receive approximately $200 (100 rights * $2.00/right). By selling, she realizes the value of the rights but accepts the dilution of her ownership percentage.
• Do Nothing: If Sarah does not exercise or sell her rights, they will expire worthless, and her ownership percentage in GreenTech Inc. will be diluted as new shares are issued to other participating shareholders.

Practical Applications

Rights offerings, which involve the issuance of a right, are a significant tool in Corporate Finance and are utilized by Public Companyes for various strategic purposes.

• Capital Raising: Companies frequently use rights offerings as a means of Capital Raising, particularly when traditional debt financing or new equity issuances to the general public might be less favorable. This method allows them to secure funds from their existing investor base, often at a lower cost compared to other forms of financing. A key advantage is that rights offerings may avoid certain shareholder approval requirements that other offerings might trigger.³
• Shareholder Protection: The fundamental application of a right is to protect existing shareholders from Dilution of their ownership interest. By giving them the first opportunity to purchase new shares, their proportionate stake and voting power can be maintained. This is particularly important for shareholders who wish to preserve their influence in company decisions.
• Market Conditions: Rights offerings can be an attractive alternative for companies seeking capital during periods of market volatility or uncertainty, as they target known investors who may already have confidence in the company.
• Regulatory Compliance: Companies issuing rights must adhere to specific regulatory requirements, including filing registration statements (such as Form S-1 or Form S-3) with the Securities and Exchange Commission (SEC) for the underlying shares. These filings, like the one for GreenTek Solutions Inc., provide detailed information about the offering to potential investors.²

Limitations and Criticisms

While rights offerings provide clear benefits, particularly for existing shareholders, they also come with certain limitations and criticisms.

One primary concern is the potential for dilution for shareholders who do not exercise their rights. If a shareholder chooses not to participate in the rights offering, their percentage ownership in the company will decrease, even though the nominal number of shares they own remains the same. This can lead to a reduction in their proportional voting power and claim on future earnings.

Another criticism relates to the signal a rights offering might send to the market. While intended as a non-dilutive way to raise capital for participating shareholders, the market might sometimes interpret a rights issue as a sign that the company is struggling financially or unable to secure funds through other, more conventional means. This perception can, in some cases, lead to a negative impact on the company's Market Value, potentially causing stock price fluctuations around the announcement of a rights issue.¹

Furthermore, the complexity of a rights offering, including the need to understand the subscription ratio, Exercise Price, and expiration date, can be a barrier for some investors. The costs associated with regulatory filings, legal fees, and potential Underwriting fees (if a standby purchaser is involved) can also be substantial for the issuing company.

Right vs. Warrant

Both a right and a Warrant are financial instruments that give the holder the ability to purchase a company's stock at a predetermined price. However, they differ significantly in their purpose, duration, and issuance.

A right, as discussed, is typically a short-term Option issued to existing shareholders, usually with an expiration period of a few weeks to a few months. Its primary purpose is to allow existing shareholders to maintain their proportionate ownership and avoid Dilution during a new share issuance. Rights are often issued at no cost to the shareholder.

In contrast, a warrant is generally a longer-term Equity derivative, often having an expiration date several years in the future. Warrants are frequently issued as a "sweetener" or additional incentive with other securities, such as bonds or preferred stock, to make them more attractive to investors. They are typically sold by the company, either attached to other securities or as a standalone instrument, and are not necessarily issued exclusively to existing shareholders. While both allow for the purchase of shares, the short-term, pro-rata, anti-dilutive nature of a right distinguishes it from the longer-term, often incentive-based function of a warrant.

FAQs

Q1: What happens if I don't exercise my rights?

If you do not exercise your rights, and they are not transferable or you choose not to sell them, they will expire worthless. Your existing shares will remain unaffected in number, but your percentage ownership in the company will decrease as new shares are issued to other participating shareholders, leading to Dilution.

Q2: Can I sell my rights?

Yes, if the rights are transferable, you can sell them in the market, often on a stock exchange, just like regular shares. This allows you to realize the value of the right without purchasing additional shares. The company's Prospectus for the rights offering will specify if the rights are transferable.

Q3: Why would a company issue rights instead of just selling shares directly?

Companies issue rights primarily to allow existing Shareholders to maintain their ownership percentage and avoid dilution. It can also be a more cost-effective way to raise capital, as it may involve fewer Investment Banking fees compared to a traditional public offering, and it targets a known investor base that already has an interest in the company.